The Tax Exempt and
Government Entities Division Is Making Progress to Detect and Deter Fraud
Within Its Customer Base, but the Impact Cannot Be Determined at This Time

September 2005

Reference Number:2005-10-161

This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.

SUBJECT:Final Audit Report – The
Tax Exempt and Government Entities Division Is Making Progress to Detect and
Deter Fraud Within Its Customer Base, but the Impact Cannot Be Determined at
This Time (Audit # 200510012)

This report presents the results of our review of the Tax
Exempt and Government Entities (TE/GE) Division’s fraud program.The overall objective of this review was to assess the impact of TE/GE Division
management’s efforts to detect and deter fraudulent activity within their
customer base by following up on recommendations made in our Fiscal Year (FY)
2003 Treasury Inspector General for Tax Administration audit report[1] and by reviewing actions planned or
initiated by TE/GE Division management since FY 2003.

Synopsis

Since our FY 2003 audit report, the Internal
Revenue Service(IRS) has learned that tax-exempt
and government entities have been increasingly involved as accommodation
parties[2] to abusive shelters.The IRS Commissioner has expressed his
commitment to increasing an enforcement presence to combat abuse within the
TE/GE Division customer base and has included this emphasis in the IRS’
Strategic Plan for 2005-2009, issued in June 2004.The Strategic Plan establishes 4 key
objectives aimed at enhancing enforcement of the tax law over the next 5 years,
including 1 that focuses directly on the tax-exempt and government entities
sector:To deter abuse within tax-exempt and governmental entities and misuse
of such entities by third parties for tax avoidance or other unintended
purposes.

We determined each TE/GE Division functional office has
individually taken steps to improve its fraud programs.For example, all offices have started
coordinating with other IRS divisions, to varying degrees, to develop fraud
cases on individuals or organizations that misuse tax-exempt entities.In addition, in March 2005, TE/GE Division
representatives from four of the Division’s five offices (the Employee Plans (EP)
and Exempt Organizations (EO) functions and the Indian Tribal Governments (ITG)
and Tax Exempt Bonds offices) and Office of Chief Counsel met with
representatives from the Criminal Investigation function, the Small Business/Self-Employed
Division, and the IRS Special Counsel to establish a Fraud Oversight Work Group
in an effort to improve coordination of potential fraudulent activity within
their respective areas.

Because of these improvements to its fraud program, the
TE/GE Division made several potential fraud referrals[3]
and was developing or assisting other IRS Divisions to develop additional
potential criminal fraud cases at the time of our audit.TE/GE Division referrals can include a single
promoter, but there can be many entities associated with the fraudulent
transaction.For example, in the past one
referral had several hundred entities associated with the case.Although the number of criminal referrals has
been limited,overall compliance has
benefited because of the increase in civil actions such as denials or
revocations of tax-exempt status, Internal Revenue Code (I.R.C.) Section (§) 6700[4]
penalty assessments, and referrals to other IRS operating divisions.However, most of the improvements and actions
taken for the fraud program were recent or still in the process of being
implemented.As a result, we could not
determine the overall impact these improvements have had on the TE/GE
Division’s efforts to detect and deter fraud.

Recommendations

We recommended the Commissioner, TE/GE Division, ensure all
functional offices strengthen their fraud programs by performing an assessment
to determine those areas most vulnerable to fraud and abuse within their
respective customer bases; provide fraud awareness training (including
technical examples) to employees; alert TE/GE Division customers of the
potential fraud scenarios that have been identified; and enhance existing
inventory systems to track and monitor potential fraud cases and fraud
referrals and the results of the examinations, investigations, and referrals.

Response

The Commissioner, TE/GE Division, agreed with our
recommendation and is implementing corrective actions.Specifically, the Directors of the EP and EO
functions and the ITG and Federal, State and Local Governments offices will
conduct assessments to determine those areas (including fraud indicators for
those areas) most vulnerable to fraud and abuse.In addition, TE/GE Division management will
continue to provide fraud training, including technical training, to those
employees within TE/GE Division Determinations or Examinations office staffs
that require such training but have not yet received it.TE/GE Division executives and senior-level
employees will continue to use speeches, newsletters, interviews, postings to
web sites, and other customer education and outreach functions and devices to
warn TE/GE Division customers of fraudulent practices that emerge within the
TE/GE Division communities and that have come to TE/GE Division management’s
attention.The TE/GE Division is
planning to use two new inventory systems and will employ them, to the degree
possible, to track fraud cases while they remain in TE/GE Division’s
control.Management’s complete response
to the draft report is included as Appendix IV.

Copies of
this report are also being sent to the IRS managers affected by the report recommendations.Please contact me at (202) 622-6510 if you
have questions or Daniel R. Devlin, Assistant Inspector General for Audit
(Headquarters Operations and Exempt Organizations Programs), at (202) 622-8500.

Although
the majority of taxpayers and Internal Revenue Service (IRS) customers comply
with the Internal Revenue Code (I.R.C.), a few willfully attempt to evade their
tax obligations by committing acts of
fraud.Tax fraud is the intentional
wrongdoing on the part of a taxpayer, with the specific purpose of evading taxes.Tax Exempt and Government Entities (TE/GE)
Division customers are generally exempt from paying income tax, so tax fraud is
generally not committed by the tax-exempt entity.However, individuals can and have used TE/GE
Division customers as a vehicle to facilitate tax fraud.

Customers of the TE/GE Division represent a
significant aspect of tax administration, with approximately 3 million entities
controlling about $8 trillion in assets and paying over $300 billion in employment
tax and income tax withholding.The fact
that these entities are exempt from Federal income tax is sometimes seen by
others as an opportunity to use the exempt entity for personal gain.TE/GE Division training material provides the
following example of an individual using a tax-exempt entity for personal gain:

An individual was the sole shareholder of a
small insurance sales company.The
individual donated the stock of a small insurance company to an I.R.C. Section (§) 501(c)(3)[5]
tax-exempt organization, which was an I.R.C. § 509(a)(3) supporting
organization, and took a large deduction for the donation on the individual’s
Individual Income Tax Return.The donor
was the president of the I.R.C. § 501(c)(3) organization that received the
stock.The stock was later determined to
be worthless since the company was just a shell.After the individual donated the stock and took
the deduction for the contribution, another company was created to conduct the
insurance sales business.The company
whose stock was donated went out of business.

In September 2003, we issued an audit report on the TE/GE
Division’s fraud program.[6]In Fiscal Year (FY) 2003, the TE/GE Division
was taking action to improve its fraud program.In developing its fraud program, the TE/GE Division decided not to
develop a division-wide program to address fraud within its customer base.Instead, each of its functional offices
(Exempt Organizations (EO), Employee Plans (EP), and Government Entities
functions) independently developed its own processes to identify and address
fraud and to communicate fraud awareness to employees, customers, and other IRS
offices.The functional offices were
given the latitude to develop their own programs because of the belief that
processes developed independently would better serve the extremely varied
customer base and regulatory authority.We
recommended the need for TE/GE Division management to:

·Formalize plans for providing fraud training for
fraud coordinators and scheduling training for the compliance staff.

·Identify areas most vulnerable to potential
criminal fraud activity within each of the TE/GE Division functions.

·Evaluate externally and internally identified
allegations or issues of potential fraud, including abusive tax schemes, to
determine the appropriate action to take, including fraud referral to the IRS
Criminal Investigation (CI) function.

·Coordinate with the CI function to determine
which potential fraud issues should be prioritized for referral to the CI
function.

Since that review, the IRS has learned that tax-exempt
and government entities have been increasingly involved as accommodation
parties[7] to abusive shelters.In June 2004, the IRS Commissioner testified
before the United States Senate Committee on Finance that the vast majority of
tax-exempt entities carry out their valuable role in full compliance with the
letter and spirit of the law, but the IRS was concerned some entities were
using their tax-exempt status to achieve ends that Congress clearly did not
intend when it conferred the privilege of tax exemption.

The
IRS Commissioner has expressed his commitment to increasing an enforcement
presence to combat abuse within the TE/GE Division customer base and has
included this emphasis in the IRS’ Strategic Plan for 2005-2009, issued in June
2004.The Strategic Plan establishes 4
key objectives aimed at enhancing enforcement of the tax law over the next 5 years,
including 1 that focuses directly on the tax-exempt and government entities
sector:To deter abuse within tax-exempt and governmental entities and misuse
of such entities by third parties for tax avoidance or other unintended
purposes.

The TE/GE Division currently has both a fraud program and an
Abusive Tax Avoidance Transactions (ATAT) program; however, these programs
cover cases at the point where indications of fraud or ATAT are
identified.When referrals are received
or indications of abuse are initially identified, it is not always known if the
case should be worked as a fraud case or as an ATAT case.These cases are generally reviewed by the Examinations
office within each TE/GE Division functional office.If fraud indicators are identified, the cases
will be worked in the fraud program.If
ATAT indicators are present, the cases will be worked in the ATAT program.It is also conceivable that a case could have
characteristics of both fraud and tax abuse and would then be worked jointly by
both programs.

Because TE/GE Division customers are
tax-exempt entities, TE/GE Division management normally refers potential fraud
cases to other IRS operating divisions or other Federal Government agencies
having jurisdiction over the individuals and corporations involved in the
potential fraud.The IRS CI function
investigates allegations of fraud for the IRS and develops cases for criminal
prosecution.

This review was performed at the TE/GE Division EO and EP
functions and the Federal, State, and Local Governments (FSLG), Indian Tribal
Governments (ITG), and Tax Exempt Bonds (TEB) Headquarters offices in
Washington, D.C.; the EP function Examinations office in Baltimore, Maryland;
the EO function Examinations and Classification officesin Dallas, Texas; the ITG Operations, Planning, and Research office in Buffalo,
New York; and the TEB Examinationoffice in
Denver, Colorado, during the period February through July 2005.The audit was performed in accordance with Government Audit Standards.Detailed information on the audit objective,
scope, and methodology is presented in Appendix I.Major contributors to the report are listed
in Appendix II.

Since our prior report in FY 2003, each TE/GE Division
functional office has individually taken steps to continue to improve its fraud
programs.For example, all offices have
started coordinating with other IRS divisions, to varying degrees, to develop
fraud cases on individuals or organizations that misuse tax-exempt
entities.In addition, in March 2005,
TE/GE Division representatives from four of the Division’s five offices (the EP
and EO functions and the ITG and TEB offices) and Office of Chief Counsel met
with representatives from the CI function, the Small Business/Self-Employed (SB/SE)
Division, and the IRS Special Counsel to establish a Fraud Oversight Work Group
in an effort to improve coordination of potential fraudulent activity within
their respective areas.This increased
coordination between TE/GE Division offices and other IRS divisions provides
IRS management the opportunity to develop issues relating to both the tax-exempt
entity and the individual or organization perpetrating the potential
fraud.

Because of these improvements to its fraud program, the
TE/GE Division made several potential fraud referrals[8]
and was developing or assisting other IRS Divisions to develop additional potential
criminal fraud cases at the time of our audit. TE/GE Division referrals can include a single promoter,
but there can be many entities associated with the fraudulent transaction.For example, in the past one referral had
several hundred entities associated with the case.Although the number of criminal referrals has
been limited,overall compliance has
benefited because of the increase in civil actions such as denials or
revocations of tax-exempt status, I.R.C. § 6700[9]
penalty assessments, and referrals to other IRS operating divisions.However, most of the improvements and actions
taken for the fraud program were recent or still in the process of being
implemented.As a result, we could not
determine the overall impact these improvements have had on the TE/GE
Division’s efforts to detect and deter fraud.We also observed that, while TE/GE management has provided assistance to
other IRS operating divisions and Federal Government agencies in developing
criminal fraud cases, they could not provide us with the overall amount of
assistance, status, and/or outcome of the cases.TE/GE Division management needs a method of
tracking its potential fraud referrals, including its collateral assistance, to
other operating divisions and Federal Government agencies, to be aware of the
issues and the status of the referrals as they are being developed for
prosecution.Information such as this
might enable TE/GE Division management to more quickly identify additional
cases that are similar to ones being developed for prosecution.

The following sections present TE/GE Division management’s
efforts to address recommendations from our FY 2003 audit report and to
strengthen their fraud program, and additional initiatives either started or
implemented since FY 2003 that are designed to enhance their ability to detect
and deter fraud.

The EO function criminal
fraud program

Since
the prior audit, EO function
management has made progress in establishing a criminal fraud program within
their function and is planning additional actions to improve their ability to
detect and deter fraud within their customer base.Their initial efforts have resulted in
several potential fraud cases that the EO function is working jointly with
other IRS divisions.The following are
the actions taken or planned for the EO function’s fraud program:

Assigning
responsibility for the fraud program – Several years ago, EO function Examinations office management
designated an agent assigned to the EO function Mandatory Review office as the EO
function Fraud Coordinator.In the fall
of 2004, EO function Examinations office management designated a senior revenue
agent as the second EO function Fraud Coordinator.A formal job description has not been
developed; however, the EO function Fraud Coordinator serves in several
different capacities, including an “advisor” or liaison to assist EO function
agents with questions or concerns regarding potential fraudulent activity.The EO function Fraud Coordinator also serves
as a sounding board, coach, and liaison to the SB/SE Division fraud technical advisors
(FTA) when it is determined there is a potential fraud issue. The EO function Fraud Coordinator also
played a key role in developing interim procedures for making fraud referrals
that were shared with EO function employees in March 2005 (see the following
section for additional information about fraud training).

Communicating
and providing training to EO function employees on their responsibility to
detect and deter fraud – EO function
management developed and delivered a training program for its front-line
employees and managers to develop skills essential to identify potential fraud
and abuse, detect emerging trends, and refer suspected wrongdoers for criminal
prosecution.A pilot course was held in
September 2004 and nearly all of the EO function’s applicable employees
received the training in March and June 2005.At the time of our review, EO function management was planning to train the rest of the EO function staff.The training course was conducted with
the assistance of instructors from the CI function.Specifically, the training material presented
the following:

·For Examinations office agents, the course material included examination
techniques to help agents recognize potential fraud during the examination of
exempt organizations.The course
material also included indicators of fraud that may be identified during
reviews of Return of Organization Exempt From Income Tax (Form 990) and Exempt
Organization Business Income Tax Return (Form 990-T).

·For Determinations office agents, the course material provided examples of fraud
indicators so the agents could react quickly, since screeners of applications
are the first line of defense against fraud.The course material also included information for identifying and
reassigning “specialty” cases (e.g., credit counseling, down payment assistance,
disaster relief) that have a high potential for fraud to the appropriate EO function
specialists who have been trained to work those issues.

Communicating with EO function customers
about fraud issues – EO
function management shared its FY 2005 Work Plan with all IRS employees via the
TE/GE Division Intranet web sites, Town Hall meetings, TE/GE Division newsletters,
and other communication sources.The
Work Plan was also distributed to Congress, State officials, tax practitioners,
and other industry stakeholders through various communication vehicles,
including media briefings, mailings, and postings to the general public.The Work Plan addresses EO function
management’s critical enforcement initiatives (e.g., combating ATATs, antiterrorism
efforts, excessive compensation, credit counseling) and planned actions for FY
2005 and the establishment of the Financial Investigations Unit (FIU) to
address fraud and tax avoidance cases.EO function management also recently developed a section on its Intranet
site for all of its critical initiatives.Each critical initiative has its own page that summarizes the issue, why
it is considered critical, key technical contacts, and other useful
information.

Other information about schemes involving potentially
fraudulent activity within the exempt organization sector was made public
through press releases and notices. Also, the IRS Commissioner, the TE/GE Division
Commissioner, and EO function executives have made presentations to a variety
of audiences to address the proliferation of abuse within the tax-exempt sector
and the EO function’s intent to combat such abuse.

Jointly developing potential fraud cases – EO function management has worked with
other IRS offices to improve the IRS’ ability to detect and deter fraudulent
activity within the EO function customer base.EO function management
held meetings with SB/SE Division Lead Development Center (LDC) management and
Large and Mid-Size Business (LMSB) Division Office of Tax Shelter Analysis
management to share information about fraud and abuse. An EO function revenue agent was detailed to
the LDC to educate LDC staff about EO function
issues and to review files with potential EO function customer involvement.Since the detail, EO function management noted an increase in referrals
from the SB/SE Division LDC.In June 2004, the EO function Fraud
Coordinator made a presentation at the FTA training seminar sponsored by the SB/SE
Division.The presentation included
discussions about the EO function’s Fraud Referral Procedures, indicators of
fraud within the EO function customer
base, and known abusive schemes within the EO function customer base.

An EO function revenue agent recently
secured the necessary security clearance and became actively involved with the
CI function’s LDC.The revenue agent
conducted a class on the Form 990 for the CI function analysts assigned to the
LDC.The revenue agent also participated
in meetings with other offices, such as the EO function Research and Analysis office,
to assist in identifying potential problem applications that have been
submitted for a determination letter.

EO function management has worked with State
charity officials for several years to improve its partnership to combat abuse
within tax-exempt organizations.While
the IRS cannot disclose tax return information (e.g., fraud investigations,
examinations, and revocations of tax-exempt status) to State charity officials,
at least 38 States require exempt organizations to file all or part of the Form
990 with the State so the States can ensure compliance with State laws.In a letter to the National Association of
State Charity Officials, dated June 14, 2004, EO function management reiterated
their desire to find additional ways to increase cooperation and improve
information sharing with the States.

EO
function management coordinates their efforts to identify exempt organizations
participating in terrorism with the Treasury Executive Office for Terrorist
Financing and Financial Crimes, State charity officials, and the CI
function.In October 2004, EO and CI
function management made a presentation at the Annual National Association of
Attorney General/National Association of State Charity Officials Seminar to
discuss antiterrorism.The training was
developed to help State charity officials recognize what kind of information
they should look for and how to decide what to do with that information.

In addition to the above, EO function
management established the FIU in April 2005 to improve their ability to deter
or detect fraudulent transactions by charitable organizations.EO function management has selected the FIU
management staff and the Unit is conducting analyses, but the Unit was not
fully operational at the time of our review.When fully staffed with approximately 20 employees, including fraud
specialists, forensic accountants, and agents with expertise in identifying
fraud and tracking foreign grant activities, EO function management anticipates
the FIU will further strengthen working relationships with the CI function and
help channel fraud referrals more effectively and efficiently.

The EO function management does not have a system in place to monitor
their fraud program.At the time of our
audit, EO function management advised us they were developing or had developed
nine potential fraud cases for referral to other offices.****1****.

Monitoring and tracking potential fraud cases and fraud referrals – The EO function is currently unable
to systemically track the number of potential fraud cases and referrals
made.In addition, EO function
management advised us they have not received feedback on some of the cases they
referred to other IRS operating divisions, and some of the cases are not yet being
tracked because they are still being prepared for referral to the CI function.

The EP function criminal fraud program

EP function
management continues to develop a criminal fraud program within their operation
and is planning additional actions to improve their ability to detect and deter
fraud within their customer base.Their
initial efforts have resulted in referral of several potential fraud cases that
the EP function is working jointly with other IRS divisions.The following are the actions taken or
planned for the EP function’s fraud program:

Assigning
responsibility for the fraud program – The EP function Determinations and Examinations offices work
together to identify and refer cases with indications of fraud to the
appropriate office for further development.The EP function Determinations office reviews applications for exempt
status[10] (Form 5300 series).[11]When
indications of inappropriate activity are identified, the application is
forwarded to the EP function Examinations office for review and development of
the fraud issue.EP function managementdesignated the manager of the Special Review section
as the Fraud manager.The Fraud manager
is responsible for developing the EP function Examinations office fraud program,
which also includes coordinating with other IRS divisions and TE/GE Division functional
offices about potential fraudulent issues relative to the employee plans
sector.In addition, a Fraud Coordinator
has been designated to handle potential fraud referrals to other IRS operating
divisions, including the SB/SE Division and the CI function.

·EP function
Examinations office management, with the assistance of the TE/GE Division Office
of Chief Counsel, the SB/SE Division FTAs, and the CI function, developed
training to help employees identify and address fraud and abuse that occurs, or
could occur, in employee plans.

The 2-hour
training material provides employees with a basic understanding of the
difference between civil and criminal fraud, general potential fraudulent
indicators relative to employee plans, and EP function Examinations office fraud
procedures.In addition, the training
material provides EP function Examinations office agents with investigative
techniques for recognizing and developing potential fraud issues when examining
employee plan cases.The material also
includes examples of potential fraudulent activity when reviewing specific
expenditures and investments and other books and records. The
training is included in the EP function Examinations office’s Continuing
Professional Education scheduled for the summer of 2005.

·The July
2004 edition of the EP function Examinations Programs Review Quality Newsletter
included an article on how to uncover fraud during the initial interview while
examining an EP function return.This Newsletter
is available to employees via the Intranet.

·EP
function Determinations office developed training material based on indicators
of inappropriate activity previously identified from applications for exempt
status.This information was presented
in a training class on February 23, 2005.The material identifies how the employees should refer cases if similar
indicators are identified.Subsequent to
the class, 20 referrals have been made to the EP function Examinations office for
further review.

Communicating
with EP function customers about fraud issues – In January 2005, the Commissioner, TE/GE Division, communicated the
EP function’s new emphasis in addressing compliance issues, including fraud,
abusive schemes, and standards of professional conduct to some members of the
EP function customer base.The
Commissioner also requested that EP function customers partner with the EP
function by referring potential inappropriate activity.In March 2005, EP function Examinations office
and EP function Customer Education and Outreach office management also began
meeting to develop a communication strategy to assist in carrying out this new
emphasis.The Director, EP, and the
Director, EP Examinations, delivered a message similar to that of the
Commissioner, TE/GE Division, on multiple occasions during FY 2005 at
conferences, at small gatherings, and during interviews with external
publications.

Jointly
developing potential fraud cases –In the past, the EP function Determinations office has
identified and referred several potential fraudulent cases to EP function Examinations
management for further development.The EP
function Examinations office has worked with the IRS SB/SE Division, the CI
function, and the Servicewide ATAT Committee to improve the IRS’ ability to
detect and deter fraudulent activity within the EP function customer base.In addition, an EP function Examinations office
representative is participating in the TE/GE Division and CI function Fraud Oversight
Work Group.At the time of our audit, EP
function management advised us they were developing or had developed six
potential fraud cases[12] for referral to other offices.They worked with the SB/SE Division on four
cases and the LMSB Division on two cases involving potential fraudulent
activity.LMSB Division management
referred the two cases to the CI function.

Monitoring and
tracking potential fraud cases and fraud referrals – The EP function Examinations office Fraud
Coordinator is responsible for tracking the number of potential fraud cases and
referrals made to other IRS operating divisions and functional offices and for submitting
a monthly report about the status of potential fraud activity to the EP function
Examinations office Fraud manager.In
addition, EP function Examinations office management prepared a Request for
Information Services to develop unique status codes on the IRS database for
cases held in suspense for potential fraud development and acceptance by the CI
function for criminal investigation.EP function
management advised that, when implemented, the new status codes will enhance
their ability to monitor and track fraud cases and fraud referrals.

We identified one
additional area that needs strengthening within the EP function’s fraud
program.

·EP
function management has not performed an assessment[13] to determine those areas (including fraud
indicators for those areas) most vulnerable to fraud and abuse within the EP
function customer base.

The FSLG office criminal fraud program

FSLG office management has
established a limited criminal fraud program, including assigning a Fraud
Coordinator and putting limited resources to fraud enforcement activities.In addition, they have made four fraud
referrals to the SB/SE Division.The Director, FSLG, advised us that the FSLG
office has jurisdiction only for employment tax issues, including the
identification of errors or omissions during employment tax examinations involving
governments.As such, they have not
conducted any type of fraud assessment and were not aware of any situations
where potential criminal fraud has occurred in areas under their jurisdiction.If indications of potential fraud are
identified, the information is forwarded to the appropriate IRS operating division
with responsibility for further development.The following are the actions taken or planned for the FSLG office’s
fraud program.

Assigning responsibility for the fraud program – FSLG office area managers periodically
perform research of media sources to determine if there is an impact on Federal
taxation for the municipality when individuals are suspected, indicted, or
prosecuted for committing fraudulent acts in their official capacities for
governmental entities.If leads are
identified that may result in a tax consequence for a municipality, they are
forwarded to the FSLG office Operations, Planning, and Review staff to open an
examination on the municipality.

Communicating and providing training to FSLG office
employees on their responsibility to detect and deter fraud – FSLG office management has provided
general fraud referral training to employees but has not provided technical
fraud training due to their belief that fraud does not exist in their customer
base.

·In March
2004, the Director, FSLG, established the FSLG office Knowledge Sharing Group
to address emerging issues and to share skills and knowledge with other
employees.The Group is currently
analyzing a potential fraud issue.

·In
January 2005, an FSLG office area manager attended a 4-day fraud seminar
conducted by theSB/SE Division.FSLG office management included the manager’s
feedback about the training on its Intranet site.In July 2004, another FSLG office area
manager attended the 5-day SB/SE Division fraud training.

·During
the April 2005 Continuing Professional Education training, the FSLG office Fraud
Coordinator discussed draft FSLG office fraud procedures (guidance that became
formal in May 2005) and the specific fraud leads referred to the SB/SE
Division. However, this training was general
in nature and not designed to include FSLG office technical issues.

·In May
2005, FSLG office management developed interim guidance for employees to follow
when they identify potential fraudulent activity.

Communicating with FSLG office customers about
fraud issues –FSLG office
management advised us their customers are victims of fraud rather than
perpetrators.As such, the Director,
FSLG, has not specifically informed customers of potential fraud scenarios. However, the
Director, FSLG, advised us that several presentations were made to their
customers where laws and procedures governing the FSLG community are discussed
(these laws and procedures, if not adequately carried out, could constitute
fraud).

Jointly developing potential fraud cases –FSLG office management has
established a working relationship with the SB/SE Division as part of their
limitedfraud program.In June 2005, FSLG office management and
SB/SE Division Fraud Policy and Field Operations management initiated a process
for FSLG office employees to refer potential fraudulent activity to the SB/SE
Division.In FY 2005, FSLG office
management referred four leads to SB/SE Division staff for fraud development.In
addition, FSLG office management began participating in the TE/GE Division and
CI function Fraud Oversight Work Group in June 2005.

Monitoring and tracking potential fraud cases
and fraud referrals – FSLG office
management does not track the status of potential fraud referrals because the
referrals involve SB/SE Division, not FSLG office, customers.Instead, FSLG office management relies on
SB/SE Division Fraud Policy and Field Operations function management to notify
FSLG office management about potential fraudulent activity involving an
individual working for or acting on behalf of an FSLG office customer (e.g., a
municipality).

We identified two additional areas that need
strengthening within the FSLG office’s fraud program.

·FSLG office
management has not performed an assessment to determine those areas (including
fraud indicators for those areas) most
vulnerable to fraud and abuse within the FSLG function customer base.

·The FSLG
office needs to work more proactively with its customers and other IRS offices
to detect potential fraud involving FSLG office customers.

The ITG office criminal fraud program

ITG office management has established a criminal fraud
program within their operation and is planning additional actions to improve
their ability to detect and deter fraud within their customer base.Their initial efforts have resulted in
several potential fraud cases that the ITG office is working jointly with other
IRS operating divisions and offices.The
following are the actions taken or planned for the ITG office’s fraud
program.

Assigning
responsibility for the fraud program – ITG office management designated a field specialist as the Fraud
Coordinator. The Fraud Coordinator is
responsible for assisting other ITG office managers and agents in the
development of potential fraud issues within the ITG office customer base.

Communicating and providing training to ITG office
employees on their responsibility to detect and deter fraud – ITG office management developed and
provided training to help employees identify and address fraud and abuse that
occurs, or could occur, in tribal governments.

·During June 2004 through May 2005, all employees
received a 4-day training course, Gaming
Compliance Training for Indian Tribal Enterprises, developed by the ITG office
staff.This training provided
instructions on detecting fraud, tax shelters, abusive schemes, United States
Code (U.S.C.) Title 31 abuses,[14]
and the illegal use of the status of Indian tribes to evade taxation within Indian
Gaming and oversight for Indian Gaming operations.The training material also provided examples
of the types of violations that can occur, identified the individuals who may
commit the violations, included the indicators of potential fraudulent activity,
and provided employees with interviewing techniques to uncover potential fraudulent
activity and the ITG office’s interim fraud referral procedures.

·By August 2005, ITG office management plans for
all Abuse
Detection and Prevention Team (ADAPT) specialists to attend the
Federal Bureau of Investigation (FBI) training on Casino Crimes and an outside
vendor’s course on casino auditing.In
the fall of 2005, the ITG office’s Fraud Coordinator is scheduled to provide
grand jury training to ADAPT specialists.

·In FY 2006, ITG office management plans to
provide expert-witness training to ADAPT specialists and six employees from the
TEB office.The training will be conducted
by SB/SE Division employees.

Communicating with ITG office
customers about fraud issues –ITG office management has a
communication strategy to educate its customer base about fraud and abuse to
improve its fraud program.

·A quarterly newsletter is provided to each
tribal government and includes articles about fraud and abuse.In two instances, members of different tribal
governments sent information items about internal financial abuse to the
ADAPT.****1****. In February and June 2004, ITG office
management also made fraud presentations to two of the largest regional tribal
governments in the country. The
presentation included an overview of the ADAPT, a description of actual fraud
schemes detected within tribal governments, and an invitation to partner with
the ITG office to combat fraud and abuse.

·ITG office management has made criminal tax
fraud awareness presentations during the FBI’s Casino Crimes training sessions
on four separate occasions.Additional
presentations are scheduled during the summer of FY 2005 and duringFY 2006.Consequently, the FBI referred to the ITG office 2 I.R.C. Title 31 cases
involving an aggregate amount of $142 million.The ADAPT, together with the SB/SE Division, is
completing the anti-money laundering examinations; the SB/SE Division is
responsible for referring the cases to the CI function, if applicable.

·ITG office management worked with two tribal
government officials and made a presentation about gaming crimes to the SB/SE
Division anti-money laundering unit.

Jointly developing potential fraud cases – ITG office management has a strategy
to establish partnerships with other agencies and IRS offices to improve its
fraud program.ITG office management and
staff participate in the FBI’s National Indian Gaming Working Group and the
National Indian Gaming Commission’s (NIGC) Indian Working Groups in Arizona, California, Minnesota, New Mexico,
and Oklahoma.

ITG office management visited the SB/SE Division LDC to
share information about how the two functions can work together to address
fraud and abuse within tribal governments.As a result, the ADAPT and the SB/SE Division LDC are working together
on four different I.R.C. § 6700 investigations, and it is anticipated
each investigation will result in referrals to the CI function.Three of the four investigations involve non-Federally
recognized tribal governments illegally obtaining Federal taxation relief.In addition, ITG office management developed
a working relationship with the CI function to improve its criminal fraud
program.As a result, CI function
management designated an analyst within their financial crimes unit to work
with the ITG office on potential fraud issues.At the time of our audit, the
potential fraud cases being worked jointly with other IRS offices and other
Federal Government agencies included the following:

·
***1****.

·
****1****.

·
****1****.

·The CI function referred to the ITG office an
information item for development.

In addition, ITG office management established the ADAPT to
work criminal tax fraud issues, abusive tax shelter activities, U.S.C. Title 31 abuses, and
issues related to the use of tribal entities by third parties to avoid
proper Federal tax reporting and oversight of transactions within tribal
governments. The ADAPT also works joint
investigations with other Federal Government agencies such as the FBI, the
Inspector General for the Department of the Interior, the NIGC, and other IRS operating
divisions and offices, including the CI function.

·The ADAPT has its own classifier[15]
to develop an inventory of potential fraud cases and to assign these cases to
ADAPT specialists.The ADAPT classifier
is responsible for developing fraud cases from information items received from
both internal and external sources.At
the time of our review, the ADAPT classifier had assigned 25 potential fraud
cases to the ADAPT specialists.

·Eight field specialists, including the ITG office’s
Fraud Coordinator, are assigned to the ADAPT.These specialists are working cases, including those that involve the
improper distribution of per capita payments to tribal members, credit card
abuse among tribal leaders, embezzlement of tribal revenue, improper conversion
of tribal assets, Federal unemployment tax abuse schemes, and illegal claims of
Federal recognition by local tribal governments for Federal taxation relief.

We identified one additional
area that needs strengthening within the ITG office’s fraud program.

·ITG office management has not performed an
assessment to determine areas (including fraud indicators for those areas) most
vulnerable to fraud and abuse within the ITG office customer base.

The TEB office criminal fraud program

Because of the unique
situation with tax-exempt bonds, TEB office management considers the potential
for abuse on all examinations.As a
result, the TEB office’s fraud program includes both civil and criminal
fraud.TEB office management advised us
almost all of the TEB office examinations involve potentially abusive transactions,
and some include the potential for fraud. Over the past 2 years, approximately
50 percent of TEB office agents’ time has been devoted to abusive arbitrage
investigations, and approximately 40 percent of the agents’ time has been
devoted to I.R.C. § 6700 penalty cases and fraud cases.Examinations for violations of I.R.C. § 6700
are related to promoter misconduct and generally result in civil penalties, but
they can also result in potential criminal fraud.According to TEB office management, at the time
of our audit, most of the 37 TEB office agents had 1 or more abusive cases in
their inventory.The following are the
actions taken or planned for the TEB office’s fraud program.

Assigning
responsibility for the fraud program –In 2001, a senior TEB office group
manager was appointed as the TEB office Fraud Coordinator.The manager is also a participant on the TEB office
I.R.C. § 6700 Committee and responsible for assisting other managers and agents
in developing potential I.R.C. § 6700 examinations, getting approval to work I.R.C.
§ 6700 cases, and evaluating cases for referral to the FTA or the CI
function.The manager is also
responsible for coordinating with the CI function.

Communicating and
providing training to TEB office employees on their responsibility to detect
and deter fraud –TEB office management developed a
training course, Procedures and
Techniques for Working Abusive Transactions.The training material was provided to all TEB
office agents in August 2004.The course
addressed I.R.C. § 6700 issues and included topics that covered burden of
proof, computation of penalties, summonses, and other general information about
fraud.The Director, TEB, advised us the
TEB office identified arbitrage as the area of highest risk and enforcement
focus.Training for TEB employees was
provided in this area and resulted in a significant criminal fraud referral.

In May 1998, the IRS established a tax-exempt bond Focus
Group, comprised of agents, managers, and counsel, which currently reports to the
Director, TEB.The Focus Group meets
with TEB office agents in an educational setting once per quarter and conducts
inprocess case reviews to provide guidance to TEB office revenue agents and
managers on specific cases.The Focus
Group is knowledgeable about cases across the country and is in a position to
help identify potentially abusive and/or fraudulent cases during field visits.

Communicating with
TEB office customers about fraud issues – TEB office management has routinely made fraud and abuse presentations
at seminars, conferences, and conventions for its customer base, including the
National Association of Bond Lawyers, National Counsel of State Housing
Authorities, American Bar Association, and other State and Federal associations.
Many of the presentations made by TEB office
management and actions taken by the IRS regarding abusive bonds have received
media attention and have been published in various news articles.In addition, TEB office personnel wereoften interviewed in professional trade publications
about abusive bond-related issues.

Jointly developing
potential fraud cases – The
TEB office used a variety of techniques to identify schemes, abusive
transactions, and/or fraud.Internet
research of public databases allows the TEB office to use very narrow search
criteria to identify related cases, including cases promoted by a single bond
attorney.Newspapers, trade journals,
and other media sources were also reviewed regularly for potential fraud
leads.The TEB office coordinated with the
SB/SE Division, CI function, Securities and Exchange Commission, National
Association of Securities Dealers, Municipal Securities Rulemaking Board, and
various offices of State Auditors for leads on abusive and/or fraudulent
transactions.

The TEB office has approximately 100 potentially abusive
cases under investigation and approximately 38 current ongoing investigations
involving I.R.C. § 6700, as well as investigations into abusive bond
transactions in which I.R.C. § 6700 examinations have yet to start.In addition, the TEB office has referred
eight attorneys to the Office of Professional Responsibility, which can disbar
a practitioner from practice before the IRS.Although the majority of the TEB office’s ongoing investigations involve
abusive bond transactions, there were several fraud referrals made by the TEB office
in the past 2 years.

At the time of our
audit, TEB office management advised us they were developing or had developed seven
potential fraud cases[16] for referral to other offices.They worked with the SB/SE Division, the Securities
and Exchange Commission, and the CI function.****1****.In addition,
the TEB office is assisting the CI function and LMSB Division involving
potential criminal activity relating to tax-exempt bonds.

·Alerting TE/GE Division customers of the
potential fraud scenarios that have been identified within the customer base.

·Enhancing existing inventory systems to track
and monitor potential fraud cases and fraud referrals and the results of the
examinations, investigations, and referrals.

Management’s Response:The Commissioner, TE/GE Division,
agreed with our recommendation and is implementing corrective actions.Specifically, the Directors of the EP and EO
functions and the ITG and FSLG offices will conduct assessments to determine
those areas (including fraud indicators for those areas) most vulnerable to
fraud and abuse.In addition, TE/GE
Division management will continue to provide fraud training, including
technical training, to those employees within TE/GE Division Determinations or Examinations
office staffs that require such training but have not yet received it.TE/GE Division executives and senior-level
employees will continue to use speeches, newsletters, interviews, postings to
web sites, and other customer education and outreach functions and devices to
warn TE/GE Division customers of fraudulent practices that emerge within the
TE/GE Division communities and that have come to TE/GE Division management’s
attention.The TE/GE Division is
planning to use two new inventory systems and will employ them, to the degree
possible, to track fraud cases while they remain in the TE/GE Division’s
control.

The overall objective
of this review was to assess the impact of Tax Exempt and Government Entities
(TE/GE) Division management’s efforts to detect and deter fraudulent activity
within their customer base by following up on recommendations made in the Fiscal
Year (FY) 2003 Treasury
Inspector General for Tax Administration audit
report[17] and by reviewing actions planned or
initiated by TE/GE Division management since FY 2003.Specifically, we:

I.Interviewed TE/GE Division (Headquarters) management
and reviewed appropriate documentation to determine the division-wide
initiatives or processes started or completed, since FY 2003, to enhance the
Division’s fraud program.

A.Determined
whether fraud educational material was developed and shared with the EOand EP function and
the FSLG, ITG, and TEB office customer bases.

B.Determined
whether EO and EP function and FSLG, ITG, and TEB office management communicated
to their employees the importance of fraud awareness, including the priority,
and methods of deterrence and detection of fraud.

E.Determined
whether EO and EP function and FSLG, ITG, and TEB office management established
procedures to ensure information items with potential fraud allegations were
worked by the Examinations field office with increased priority.

F.Determined
whether the EO function has taken action to identify fraudulent charity
organizations being used to fund terrorist activities.

G.Determined
whether EO and EP function and FSLG, ITG, and TEB office management established
any other processes or procedures not described in Steps II.A.-F., to enhance their
ability to detect and deter fraudulent activity.

1.Determined
the volumes, type(s), and status of potential fraudulent tax schemes/cases that
were:

a.Referred
to other IRS operating divisions or functional offices or to other Federal Government
agencies.

b.Accepted
by the Criminal Investigation function for development for criminal
prosecution.

2.Determined the
volumes, type(s), and status of any other type of enforcement actions taken by
the EO or EP functions and the FSLG, ITG, or TEB offices (e.g., fraud
penalties, revocation of exempt status) since FY 2000, other than the two
scenarios noted in Step II.H.1..

[2] The term
“accommodation party” is used to describe the tax-exempt entity’s involvement
in a transaction that does not necessarily affect the entity’s primary function
but is designed to provide tax benefits to a third party that is a taxable
entity.

[3] Because
of the limitations imposed by I.R.C. § 6103 (2004), we did not include the
details of specific case information developed by the TE/GE Division for
referral to other business units or to the Criminal Investigation function for
development for criminal prosecution.

[4] I.R.C. §
6700 (2004) was originally intended to allow the IRS to impose penalties
against promoters of abusive tax shelters, but, in 1989, Congress stated the
agency could apply the penalties to municipal bond transaction participants
that are responsible for ensuring compliance with tax law or tax regulations.

[7] The term
“accommodation party” is used to describe the tax-exempt entity’s involvement
in a transaction that does not necessarily affect the entity’s primary function
but is designed to provide tax benefits to a third party that is a taxable
entity.

[8] Because
of the limitations imposed by I.R.C. § 6103 (2004), we did not include the
details of specific case information developed by the TE/GE Division for
referral to other business units or to the CI function for development for
criminal prosecution.

[9] I.R.C. §
6700 (2004) was originally intended to allow the IRS to impose penalties against
promoters of abusive tax shelters, but, in 1989 Congress stated the agency
could apply the penalties to municipal bond transaction participants that are
responsible for ensuring compliance with tax law or tax regulations.

[10] EP
function specialists analyze the applications to determine if the employee
plans are established in a manner that meets current laws and are substantially
compliant with the I.R.C. and any applicable Revenue Procedures.

[11] The
Forms 5300 series returns include Application for Determination for Defined
Benefit Plan (Form 5300) and Application for Determination Upon Termination
(Form 5310).

[12] This
does not include potential fraud cases referred by the EP function
Determinations office that were outside the time period of this audit.These earlier cases had not been resolved as
of the time of this audit.

[13]EP function management is currently
performing an assessment of 79 market segments to identify areas of high risk
for examination in each particular market segment.However, fraud indicators were not included
in the market segment analysis.

[15] A
classifier is responsible for evaluating information items for workload
selection, prioritizing inventory for assignment to field groups, and recording
the results of compliance and enforcement actions taken by field specialists.

[16] The 7
potential fraud cases included at least 26 bond examination cases and 13 I.R.C.
§ 6700 examinations.In addition, one
potential fraud referral actually included eight different cases but was
written as one referral to simplify the process.